Large banks in Europe struggle with weak bonds

Ever since the European debt crisis began, the risk of contagion ? of problems spreading from smaller countries to bigger ones, like Italy and Spain ? has worried government officials and investors. UniCredit, the Italian bank, reported better-than-expected earnings on Wednesday, but the value of bonds it holds has plunged. Now, another type of contagion is causing concern the risk of problems spreading to big banks.

The growing vulnerability of the giant banks in these two countries is spurring investor fears that Europe?s latest bid to get a handle on its festering debt crisis, adopted just a few weeks ago, has come up short.

The banks own so many bonds issued by their home countries that they are being weakened as the value of those bonds falls, amid concerns that the cost of government borrowing could become too expensive for Italy and Spain to bear.

Now there are signs that these concerns are, in turn, starting to making it harder and costlier for the banks to borrow money to finance their day-to-day operations, a troubling trend that, at the worst, could lead to liquidity problems.

Since Europe?s second major rescue package was announced last month ? aimed as much at calming fears over Spain and Italy as providing funds to Greece ? the yields on Spanish and Italian bonds have hit more than 6%, sharply higher than they were paying on new borrowings a couple of months ago.

In doing so they have entered what analysts refer to as the danger zone for 10-year bond yields, with the cost of government borrowing so high that investors become unnerved, as was the case with bailed-out Greece, Portugal and Ireland.

Bearing the immediate brunt of this development are regional banking heavyweights such as UniCredit in Italy and Santander and BBVA in Spain, which traditionally have been reliable financing machines to their home governments and as a result are now saddled with large bond holdings that are losing value by the day. Many hold domestic bond portfolios that exceed their capital levels.

According to a report by Sanford Bernstein, UniCredit?s exposure to mostly Italian bonds is 121% of its core capital ratio. For Intesa, a less-diversified competitor, that figure rises to 175%. For Spain, the ratios are a startling 193% for BBVA, Spain?s second-largest bank, and a less alarming 76% for the global banking giant Santander.

As a result, the markets have begun to focus on warning signs that some European banks are finding it harder to meet their funding needs, especially in dollars. They are borrowing larger amounts directly from the European Central Bank in its weekly lending operations, suggesting they can?t find all the money they need from the private sector to keep themselves going.

Analysts said perhaps most worrying was that the rate it costs European banks to borrow dollars in the open foreign exchange market, by swapping their holdings of euros, has shot up twofold in the past few days ? still far below the levels seen in 2008 when the market virtually froze but the highest since May 2010 when the European debt crisis started to intensify.

Recent write-offs by French banks over their own Greek bond holdings have compounded fears over the health of Europe?s banks.

?I don?t think anyone wants to be long European banks right now,? said Simon White, an analyst and partner at Variant Perception.

Even worrying is the fact that the European Financial Stability Facility, Europe?s so-called bazooka rescue fund that it endowed last month with the powers to recapitalise weak banks, will not be able to offer any such aid for at least two months.

According to a stability fund official, staff members there are working night and day to recast the entity, but do not expect to be finished until the end of August.

At that point, it must be approved by the parliaments of the 17 countries that use the euro currency. Only then could it go to the market and raise funds to help a bank in need. That may well be too late.

As investors flee Spanish and Italian government bonds, these huge bond holdings have become a significant millstone on their countries? banks ? curbing their ability to lend and, consequently, heightening the prospect of a double-dip recession in Italy and Spain, two of the euro zone?s slowest-growing economies.

Despite their best efforts to deleverage, all these banks have loans that significantly exceed their deposits. That makes them dependent on the good lending graces of their banking peers in Europe and the United States. This is one of the reasons American money market funds had more that 40% of their assets invested in European banks.

Standard banking practice has been for these banks to put up as collateral their home market government bonds, which in the past were seen as liquid, risk-free investments ? much like US Treasuries.

If, as was the case with Ireland and Greece, lenders stop accepting these bonds or start demanding more of the bonds to reflect their lower value, these banks may no longer be able to access the day-to-day financing that is their life blood.

This is what happened during the crisis in the fall of 2008, when banks stopped lending to one another, causing markets to seize up ? and leading the government to bail them out or risk the weakest banks failing.

?You could have a CFO of a lending bank say, ?Look, I just do not want to take this credit risk,?? said Marcello Zanardo, a European Bank analyst at Sanford Bernstein. ?We are not there yet ? but it is not impossible to get there.? What is worrying many bank analysts is that, in an investor panic, one might get there sooner rather than later.